Calculators

A Public Pension and Full Social Security Benefits? No Way

EDITOR'S NOTE: This article was originally published in the August 2010 issue of Kiplinger's Retirement Report.

Perhaps you had two careers. In one job, you were a government employee whose earnings were exempt from the Social Security payroll tax. You also worked in the private sector, paying into the Social Security system. When you retire, you'll get your public pension, but don't count on getting your full Social Security benefit.

Under federal law, any Social Security benefits you earned will be reduced if you were a federal, state or local government employee who earned a pension on wages that were not covered by Social Security. Reductions also apply to Social Security spousal or survivor benefits that are claimed by government pensioners.

David Walrath, a lobbyist for the California Retired Teachers Association, says many government employees don't realize their Social Security will be squeezed until they apply. "People will get their annual statement with a benefit number, but they're not told they're subject to an offset," says Walrath, with the consulting firm of Murdoch, Walrath & Holmes, in Sacramento, Cal.

The two rules that cover government employees are the "windfall elimination provision" (WEP) and the "government pension offset" (GPO). The WEP applies to workers, and the GPO applies to government pensioners who are applying for Social Security spousal and survivor benefits.

Patricia Kohlen got hit by both. Kohlen, 61, paid into a public pension system for 28 years when she worked as an elementary school teacher in Atascadero, Cal. She also worked part-time as a secretary and paid Social Security taxes through that job.

Just before Kohlen retired with a disability in 2003, her statement showed that she was due $247 a month in Social Security disability payments. The windfall provision reduced the payments to $108 a month. Her monthly teacher's pension is currently $1,930.

The big shock came when she asked the Social Security Administration about a survivor benefit after her husband, Kenneth, died at age 62 in 2006. A retired college professor, Kenneth was getting a Social Security benefit of $1,406 a month, plus a private pension of $4,000 a month.

Widows and widowers are typically eligible for a Social Security survivor benefit that's 100% of the deceased spouse's benefit. Because of the formula used to calculate the government pension offset, Kohlen was told she would receive nothing when she became eligible for a survivor benefit at age 60.

Kohlen, who lives in San Luis Obispo, Cal., says she and Kenneth had been counting on his Social Security payments. "He paid into Social Security for 49 years, and I feel, as a widow, that I am entitled to that money," she says. "It's just so terribly unfair."

Lawmakers on Capitol Hill have introduced legislation that would end or modify the two provisions. Don't expect any decision soon. These issues will likely be addressed only when Congress takes up the larger issues of Social Security solvency and deficit reduction.

In the meantime, you need to become familiar with the two rules if you ever worked in a job that was not covered by Social Security. While some federal, state and local employees have paid into Social Security, others have not. Most federal employees today are covered by Social Security. Check with your employer or former employer. Also, if your Social Security statement lists $0 for years you worked for a government agency, that's an indication you may be subject to the two rules.

First, let's look at the windfall elimination provision. To understand how the WEP works, you need to know how Social Security calculates benefits. Social Security looks at the average monthly earnings for the years a person paid into the system. Benefits are intended to replace a percentage of a worker's preretirement earnings. Lower-income workers get a larger percentage of their earnings replaced than higher-income workers.

Until the mid 1980s, the Social Security Administration used a formula that treated government employees, who may have contributed into the system for only a few years, as low-wage workers. As a result, public employees received a disproportionately large Social Security benefit -- plus their government pension. In 1983, Congress ended this so-called windfall.

The windfall provision does not apply to government pensioners who paid into the Social Security system for 30 years or longer. Nor does it apply to workers who receive a military pension or a private pension. You can use a WEP calculator at www.socialsecurity.gov to figure your benefit.

As with all Social Security beneficiaries, your WEP-reduced benefit could change based on your age when you claim it. Consider this example: After 20 years of covered earnings, you turn 62 in 2009. Your full monthly benefit at 66 would be $1,372, which is reduced $372 by the windfall provision. If you claim at 62, your benefit would be reduced by 25%, to $750. For each year you delay past 66, you get an 8% delayed-retirement credit until you reach 70.

For Survivor and Spousal Benefits

A government pensioner who applies for a spousal or survivor benefit based on his or her spouse's Social Security earnings record will also face cuts. Typically, a spousal benefit is about 50% of a husband or wife's benefit if that's more than the spouse would receive based on his or her own work record. A survivor generally receives 100% of a deceased spouse's benefit.

But if the government pension offset applies, your Social Security spousal or survivor benefit will be reduced by two-thirds of your government pension.

Let's look at Patricia Kohlen, the retired schoolteacher. The earliest a survivor can apply for a benefit is age 60, six years before full retirement. A survivor benefit is reduced by 28.5% if a widow or widower applies that early. If Kohlen had applied at 60, as she had hoped, the survivor benefit would have been reduced to $1,005, from Kenneth's monthly $1,406 benefit.

Then the GPO would kick in. At the time, Kohlen's teacher pension was a little less than $1,900. Two-thirds of $1,900 is $1,266. Because $1,266 is larger than $1,005, she was not eligible for a Social Security survivor benefit at age 60.

The same goes for spousal benefits. Assume your wife receives a $2,000 Social Security payment each month. You want to take a $1,000 spousal benefit. If your public pension is $1,200, your spousal benefit would be reduced to $200. (That's $1,000 minus $800, which is two-thirds of $1,200.)

It's Never Too Late for a Roth IRA

EDITOR'S NOTE: This article was originally published in the July 2010 issue of Kiplinger's Retirement Report.

OUR READERWho: Bill Segur, 60Where: Wilmington, N.C.Question: I've finally paid off my mortgage. What should I do with the extra cash?

Now that they've paid off their home loan early, Bill is wondering how he and his wife, Susan, should use the extra $600 a month. Bill is a registered nurse at a hospital and hopes to retire in a few years. He wants to maximize what he and Susan (also an RN) are socking away while they're still working. So their focus is on adding to their savings kitty.

Bill and Susan, 54, figure they have three options. They can increase their contributions to their 403(b) and 401(k) retirement plans, add more to their established traditional IRAs, or start up Roth IRAs. Bill appreciates the tax advantages of a Roth. Although there is no upfront tax break, all withdrawals, including investment earnings, are tax-free once you are 59 1/2 and the account has been open at least five years.

But Bill wonders whether it makes sense for him and Susan to open Roths at their age. "At this late date in our work experiences, do we start new Roth IRAs or add to our traditional accounts?" he asks. The couple have an adequate emergency savings fund and little debt, so they can comfortably bulk up their retirement assets.

Carlo Panaccione, a financial planner in Redwood City, Cal., says that Bill and Susan should pat themselves on the back for paying off their mortgage and committing to put the money toward savings rather than going on a spending spree. "People always say: "If I have money left at the end of the year, I'll save it,'" says Panaccione. "It never happens." Instead, he says, household budgets simply tend to expand whenever a family has money to spare.

Tax advantages. So, to answer Bill's question directly: It's not too late to start a Roth IRA. Because both Bill and Susan are older than 50 and their joint income is less than $167,000, each of them can contribute the maximum $6,000 (including $1,000 in catch-up contributions) to a Roth in 2010.

No matter how long you maintain the retirement account, the tax benefits of a Roth are simply too good to pass up. When you withdraw money from a 401(k) or a regular IRA, it's taxed at your ordinary income-tax rate. With a Roth, you can withdraw cash in retirement without paying Uncle Sam a penny.

And once Bill and Susan retire, they won't need to tap their Roth IRAs right away, given their modest living expenses, their income from workplace retirement plans and Social Security. Because Roths have no required-minimum-distribution rules, you can leave the investments in place as long as you like. "That money can just sit there and cook," says Larry Rosenthal, a financial planner in Manassas, Va. With income-tax rates likely to rise to offset growing budget deficits, the Roth stands out as an increasingly valuable tax shelter. In other words, it's a good way for the couple to diversify their future tax liability.

Roth accounts could also prove helpful to Bill and Susan's estate planning. They can leave the accounts to their two daughters, who would inherit them tax-free.

Tax Rules for Second Homes

EDITOR'S NOTE: This article was originally published in the Sept. 2010 issue of Kiplinger's Retirement Report.

If you are in the market for a second home, congratulations! Not only can you look forward to having a place to relax, you also can garner some tax benefits for that place in the mountains or at the beach. You can use several tax breaks:

Mortgage interest. If you use the place as a second home -- rather than renting it out as a business property -- interest on the mortgage is deductible just as interest on the mortgage on your first home is. You can write off 100% of the interest you pay on up to $1.1 million of debt secured by your first and second homes and used to acquire or improve the properties. (That's a total of $1.1 million of debt, not $1.1 million on each home.) The rules that apply if you rent the place out are discussed later. Property taxes. You can deduct property taxes on your second home, too. In fact, unlike the mortgage interest rule, you can deduct property taxes paid on any number of homes you own.

If you rent the home

Lots of second-home buyers rent their property part of the year to get others to help pay the bills. Very different tax rules apply depending on the breakdown between personal and rental use. If you rent the place out for 14 or fewer days during the year, you can pocket the cash tax-free. Even if you're charging $10,000 a week, the IRS doesn't want to hear about it. The house is considered a personal residence, so you deduct mortgage interest and property taxes just as you do for your principal home.

Rent for more than 14 days, though, and you must report all rental income. You also get to deduct rental expenses, and that gets complicated because you need to allocate costs between the time the property is used for personal purposes and the time it is rented.

If you and your family use a beach house for 30 days during the year and it's rented for 120 days, 80% (120 divided by 150) of your mortgage interest and property taxes, insurance premiums, utilities and other costs would be rental expenses. The entire amount you pay a property manager would be deductible, too. And you could claim depreciation deductions based on 80% of the value of the house. If a house is worth $200,000 (not counting the value of the land) and you're depreciating 80%, a full year's depreciation deduction would be $5,800. You can always deduct expenses up to the level of rental income you report. But what if costs exceed what you take in? Whether a loss can shelter other income depends on two things: how much you use the property yourself and how high your income is.

If you use the place more than 14 days, or more than 10% of the number of days it is rented -- whichever is more -- it is considered a personal residence and the loss can't be deducted. (But because it is a personal residence, the interest that doesn't count as a rental expense -- 20% in our example -- can be deducted as a personal expense.)

If you limit personal use to 14 days or 10%, the vacation home is considered a business and up to $25,000 in losses might be deductible each year. That's why lots of vacation homeowners hold down leisure use and spend lots of time "maintaining" the property. Fix-up days don't count as personal use. The tax savings from the loss (up to $7,000 a year if you're in the 28% tax bracket) help pay for the vacation home. Unfortunately, holding down personal use means forfeiting the write-off for the portion of mortgage interest that fails to qualify as either a rental or personal-residence expense.

We say such losses might be deductible because real estate losses are considered "passive losses" by the tax law. And, passive losses are generally not deductible. But, there's an exception that might protect you. If your adjusted gross income (AGI) is less than $100,000, up to $25,000 of such losses can be deducted each year to offset income such as your salary. (AGI is basically income before subtracting your exemptions and deductions.) As income rises between $100,000 and $150,000, however, that $25,000 allowance disappears. Passive losses you can't deduct can be stored up and used to offset taxable profit when you ultimately sell the vacation house.

Tax-free profit. Although the rule that allows home owners to take up to $500,000 of profit tax-free applies only to your principal residence, there is a way to extend the break to your second home: make it your principal residence before you sell. That's not as wacky as it might sound. Nor is it as lucrative as it used to be.

Some retirees, for example, are selling the big family home and moving full time into what had been their vacation home. Before 2009, this had a very special tax appeal. Once you live in that home for two years, up to $500,000 of profit could be tax free – including appreciation in value during the years it was your second home. (Any profit attributable to depreciation while you rented the place, though, would be taxable. Depreciation reduces your tax basis in the property and therefore increases profit dollar for dollar.)

Congress cracked down on this break for taxpayers who covert a second home to a principal residence after 2008. A portion of the gain on a subsequent sale of the home is ineligible for the home-sale exclusion of up to $500,000, even if the seller meets the two-year ownership and use tests. The portion of the profit that’s subject to tax is based on the ratio of the time after 2008 when the house was a second home or a rental unit to the total time you owned it. This can still be a great deal if you’ve owned your second home for many years before the law changed.

Let’s say you have owned a vacation home for 18 years and make it your main residence in 2011. Two years later, you sell the place. Since the two years after 2008 the place was your second home (2009 and 2010) is 10% of the 20 years you owned the home, only 10% of the gain is taxed. The rest qualifies for the exclusion of up to $500,000.

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* In states other than Florida, Michigan, and Texas, the maximum owner occupied CLTV (combined loan to value) for a PenFed Home Equity Loan is 85%, non-owner occupied is 75%. In Florida and Michigan, the maximum owner occupied CLTV is 70%. In Texas, the maximum owner occupied CLTV allowed is 80% and non-owner occupied is CLTV 75%. Additional restrictions apply in Texas, so please ask a representative for details. The maximum CLTV on condominiums in all states is 70%.